Question

In your role as a business owner or employee and as a private consumer, you are an active participant in the economy. Your consumption and saving decisions have an impact on the economy. Keeping in mind the lessons you learned in the last two chapters about AD/AS modeling please respond to the following scenario:

Assume you are a member of the Federal Reserve Board. Over the last six months you have seen the U.S. unemployment rate drop from 5.4% to 3.8%. What would this drop indicate to you and what would be your biggest economic concern be? In your next Federal Reserve meeting, what action would you recommend be taken to mitigate or alleviate the concern you identified?

Answer 1

A fall in unemployment rate signifies an increase in aggregate demand, in which case price level is higher. Another possibility is that aggregate supply has increased (thereby increasing the demand for labor and decreasing unemployment), in which case price level will be lower (causing deflation). But assuming the Short-Run Phillips Curve of an inverse relationship between inflation and unemployment rate will hold true, I consider that aggregate demand has increased.

This will give rise to higher inflation which is the biggest economic concern. To tame inflation, I would suggest a decrease in money supply, by open market sale of Federal securities to mop up excess liquidity from the system, which will increase the interest rate, in turn decreasing investment demand and the portion of consumption demand funded by borrowing. As a result, aggregate demand will decrease, lowering inflation rate.